Japan: The path to financial health
A Commentary
By Stefan Ingves, Director, Monetary and Finance Department
and Paul Hilbers, Advisor, Monetary and Finance Department
International Monetary Fund
Published in South China Morning Post, November 13, 2003 and Bangkok Post, November 17, 2003

For years the Japanese authorities have been deluged with all manner of advice on how to restore the country's economic fortunes. They have frequently been criticised for inaction or for responding too slowly and too conservatively in tackling the economy's problems. An apparent reluctance to confront the chronic weakness of the financial sector has been the particular focus of much of this criticism.

It is certainly true that Japan's financial sector remains disturbingly weak. Putting it back on a sound footing requires significant reform. But it would be wrong to dismiss out of hand changes that have already been made. The Japanese authorities recently opened their financial system to review by the international community. It joined a list of almost 60 other countries-such as many industrialised economies, for which the International Monetary Fund has completed a Financial System Stability Assessment.

These assessments, introduced in 1999, aim to help countries develop or maintain sound financial systems. They try to monitor compliance with internationally-agreed financial sector standards and codes.

The IMF's assessment for Japan was published last month. It noted that important steps have already been taken to strengthen the financial system. The Financial Services Agency has been established as the integrated supervisor for banks, insurers and securities firms. The authorities have recapitalised major banks where this was judged necessary to mitigate systemic risks. They have also enhanced the financial sector safety net. The banks themselves have been active, too. In response to the 2002 Programme for Financial Revival, they have tried to improve their capital adequacy, raise provisioning for bad loans, and accelerate the disposal of those loans.

These are all moves in the right direction. But many serious problems remain. The capital positions and profitability of banks and life insurers are thin. Non-performing loans may be declining, but from an uncomfortably high level. And financial institutions remain exposed to significant market and credit risks.

In the banking sector, it is important to ensure that banks have adequate capital, and to give them better incentives to dispose of bad loans. That means improving the system for determining bad loans, and strengthening the provisioning requirements to deal with them.

With the banking system's capital cushion left with so little padding, failure to address the issue of capital adequacy will delay resolution of the bad loan problem and so constrain the supply of credit. Once proper provisioning is in place, those banks that still need more capital should first attempt to raise it in the markets. Those that cannot manage this, but that remain systemically important, should be recapitalised with public funds-but as a transitional measure until the banks can be returned to private ownership. Non-viable institutions should be wound down or merged.

As a condition for public recapitalisation, banks should adopt corporate governance reforms consistent with international best practice. In this context, the government's recent Resona Bank rescue operation-the replacement of top management and the appointment of a majority of outside directors to the board-is encouraging.

Life insurance companies have also been under a lot of financial stress as falling investment income and stock prices have weakened their capital bases. Solvency margins for a number of insurers have been eroded, though all still remain above the regulatory minimum. And with investment returns falling below the yields guaranteed to policyholders, a "negative spread" problem has developed. The vulnerabilities of the insurance sector could spill over into the banking system through cross-shareholdings.

Solving these problems again requires the industry to face up to its weaknesses. Life insurers should be required to revalue their policy liabilities to take account of lower investment returns, and to set aside sufficient reserves to cover future liabilities to policyholders.

To complement these steps, the public sector's role in financial intermediation should be scaled back. Currently, the Japan Post-the largest deposit-taker in the world-and other public financial institutions enjoy privileges that reduce the ability of private banks and insurance firms to compete-and so constrain bank profitability.

A healthy economy is also a perquisite for a healthy financial sector. The two go hand-in-hand, and so should policies aimed at delivering them. Financial sector reforms should accompany-rather than precede-corporate restructuring, economic policies to combat deflation and medium-term fiscal consolidation.

In the short-term, the consequences of such a wide-ranging approach might be painful, but the longer-term benefits would be substantial. And the long-term costs of inaction would be greater.